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Legal Basics & Texas Business Entity Formation
When we first started out, our company was small, nimble, and not yet interested in investors. We relied heavily on the advice of our corporate lawyer. She formed our company as an LLC to personally protect us from the liabilities of the business, and to keep our administrative costs and efforts low. As our business grew, we sought advice from a second set of lawyers. They urged us to convert to a Corporation in preparation for some serious fundraising.
While we have always entertained the idea of taking on investors, that was not the key focus of our business at the time. We spent thousands of dollars in legal fees to prepare ourselves for the conversion process, but the night before we were to file, we decided to pull the plug on the whole thing. Something in our guts told us it was the wrong decision, and we confirmed this by seeking the advice of other entrepreneurs and lawyers. We may have wasted thousands of dollars in legal fees in the short run, but we know we saved ourselves even more in the long run.
Starting a business is a constant learning process through trial and error, and even the experts are not immune to making mistakes. It is important to know what you want out of your business, out of your legal structure, and out of the people you bring onboard to your company so that you aren’t too influenced by outside interests that don’t align with your own. Read on to get a better idea of which business formation is right for you so you can make the best decision possible when forming a legal entity.
1. Sole Proprietorship
To be a sole proprietor takes little, to no, legal work. If you are your business, and you haven’t completed any legal work to form a separate entity for your company, you are, by default, a sole proprietor. As a sole proprietor, anything that happens to your business also happens to you as a person. If a client decides to sue your business, they are personally suing you. As a sole proprietor, you are also responsible for the revenues and debts of the business – so if you run into choppy waters, and incur debts, you may need to sell your personal belongings to cover them – or file for personal bankruptcy. A sole proprietor also needs to report all business income as personal income, and pay taxes accordingly. Since there are no provisions for additional shareholders in a sole proprietorship, it will be difficult to ever attract investors in this form.
As a sole proprietor, the legal name of your business is by default the same as your personal legal name. If you want to operate the business under a different name, you can file to operate as a DBA, or “doing business as.” There are a lot of reasons why you would want to operate your sole proprietorship as a name different than your own. Some banks will not allow you to have a business bank account and a personal bank account in the same name. A single person may also decide to have multiple businesses; sometimes it helps keep things organized and cuts down on paperwork if you can operate the different business under different legal names. Not only does this help with paperwork, but it helps your customers distinguish the differences in the brands associated with each business. The process of registering for a DBA alone can help you think through the trademark process, and confirm you are not infringing on the name or the brand of a competitor. By taking someone else’s name or likeness, you open your business up for all sorts of legal ramifications down the road.
2. Limited Partnership
It is often a good idea to form a Limited Partnership if you have two or more people teaming up, each with different desired levels of involvement and responsibility. Not everyone in a Limited Partnership can be Limited Partners, however. It is important to designate at least one general partner who has management authority, and essentially runs the day-to-day operations of the business. The general partner also has personal liabilities tied to those of the business. The Limited Partnership does require at lease one Limited Partner. The Limited Partner, often referred to as the LP, is a passive investor in the company, and has no legal authority to run the business day-to-day. If you are considering investors, a Limited Partnership may be the right situation for you.
Limited partners can invest cash, but still completely protect themselves from the personal liabilities associated with the business. If things go under, the only thing they stand to lose is the exact amount of cash they put into the business. Limited Partnerships also allow for pass-through taxation, which means the partners only get taxed once on their share of income, instead of getting taxed a second time in the form of taxes on business profits.
To form a Limited Partnership, you need to apply with the Secretary of State. It’s also a great idea to detail all of the terms of your Limited Partnership in the form of a Limited Partnership Agreement. A Limited Partnership can also outlive some of its members; Limited partners can leave the business at any time without having to dissolve the partnership, but if a General Partner leaves, then the whole relationship needs to be dissolved.
3. Limited Liability Partnership
LLPs are business structures that have more than one partner, and are attractive to business professionals. All of the partners in an LLP share some level of management decision-making and ownership of the business—but by forming an LLP, they are not responsible for the debts incurred by the business, or by malpractice performed by one of their other partners. LLPs are usually made up of teams of licensed professionals (think lawyers or accountants), and some states even require that you be a licensed professional to form an LLP in the first place.
Limited liability partnerships share the same tax benefits of Sole Proprietorships and Limited partnerships, and function as “pass-through entities.” Partners account for profits and losses on their individual tax returns, and the LLP does not pay additional income taxes.
4. LLC
A Limited Liability Company, or LLC, is a business entity that functions as a hybrid between a sole proprietorship and a corporation. Just like a corporation, the members of an LLC are personally shielded from the company’s debts. Similarly to a sole proprietorship or a partnership, an LLC has operating flexibility and is, by default, a “pass through” entity for tax purposes.
This means that the LLC does not pay taxes on its profits, but instead, profits and losses are “passed through” to the owners, who must then pay tax on their share of LLC income. By offering a lot of the protection of a corporation, but the flexibility of a sole proprietorship or partnership, an LLC is often the preferred business structure for a small and growing business.
Another key reason that new businesses will pick an LLC over a corporation is that there are significantly fewer operating and tax reporting requirements. All of that paperwork and legal work can really bog a young company down. LLC’s include operating agreements, or LLC agreements, that outline the purpose of the business, and any roles and requirements of the members who make up the LLC. As an LLC, we include our founders agreement inside of our operating agreement so that we know the specific roles and responsibilities of our two co-founders.
5. Corporation
If a business operates as a corporation, the business is its own legal entity / person, separate from that of its owners. The legal obligation of the officers of a corporation is to maximize profits. The business owners, referred to as shareholders, are not liable for debts or other claims against the corporation. This provides the ultimate form of protection for shareholders from lawsuits and bankruptcy.
A corporation can be classified as a C corporation or an S corporation, which impacts how they are taxed. C corporations are taxed twice; first on the net income the business earns while it remains inside the corporation, then again on the income when it is distributed to its shareholders. S corporations are pass-through entities, and only taxed once. They are popular with small businesses, but they only allow for up to 100 members.
If you are looking for outside investors, the stricter formalities of a C-Corporation give investors the knowledge they desire about how your company is run. This makes running a C Corporation a much more administrative-heavy and tedious task, but they satisfy more share-holders and have greater tax planning flexibility.
B-Corporation
A B-Corporation, or Benefit Corporation, is a for-profit business whose purpose is to maximize profits and to create general public benefit, defined as “a material positive impact on society and the environment.” Benefit corporations are taxed the same way as C-Corporations, but are required to be more transparent and accountable for their purpose-driven activities. A benefit corporation’s management structure is the same as a C corporation, but officers of the corporation have a legal requirement to consider the greater public good in their decision-making in addition to maximizing profits (which is their sole legal responsibility in a C-Corp). B-Corps are required to publish annual reports on the good they are doing. There are around 12 third-party standards that B-Corporations must fulfill in their role of B-Corporations, but nobody can really hold them accountable except for their share-holders. The classification as a B-Corp is a more recent phenomenon, and provides more marketing and PR benefits than it does actual financial benefits.
6. Non-Profit
If you are involved with a charitable cause, it may benefit you to formally organize your efforts into a non-profit organization. Though it may take time and effort to get your non-profit status approved, once you do you can qualify for private and public grants, low-cost postage rates and be exempt from income, sales and property taxes.
Most importantly, only a formal nonprofit can allow for people to make donations without paying taxes, and formally shield your personal assets from the charity’s liabilities. Allowing for tax-deductible donations will infinitely improve your ability to fundraise.
Once you form your charity as a formal non-profit within your state, make sure to apply for a federal tax exemption with the IRS. The federal tax exemption grants you status as a 501(c)3 organization, which is the most common section within the tax code that deals with non-profits. Another common tax exemption code is 501(c)(7), which applies to social and recreational clubs.